Observations for Long-Term Investors

Some academic papers provide good strategy

Before we move away from the world of academia I want to consider the paper that Robert Novy-Marx wrote on the subject of quality stocks and their performance compared to the market.

In the 2012 paper, The Other Side of Value: The Gross Profitability Premium, Novy-Marx made two observations that might be important to long-term investors. First, he found that profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market predicting the cross-section of average returns.

Profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios. Buying those companies that are highly profitable is going to earn about the same as a portfolio based on low price to book value.

The second incredibly useful observation in the paper is that the two strategies are not highly correlated. Both outperform the market over time, but one portfolio tends to zig while the other zags in response to market and economic conditions at any given point in time. A portfolio that uses both strategies could very well earn higher returns with less volatility over the long run.

Although I am a pure value guy at heart, in practice a portfolio of both strategies rebalanced annually could easily replace an outperform an index approach -- or blindly trying to swing trade popular stocks for long term investors. It would seem to be perfect for ultra-long-term portfolios like retirement and education accounts.

I looked this morning at which stocks fit the current definition of high quality, using Novy- Marx's rule of quality. His works suggest that the best measure in total assets divided by gross profits. In his paper he writes that "gross profits is the cleanest accounting measure of true economic profitability. The farther down the income statement one goes, the more polluted profitability measures become, and the less related they are to true economic profitability." The idea has a lot of merit and the math is compelling. The portfolio used in the paper is the 500 largest non-financial companies so I decided to search for stock that make the list today. That limits our universe of high - quality stocks to this with market caps greater than $750 million. The list really is something of a blue chip investor's dream portfolio. The top five stocks ranked by market cap are Microsoft (MSFT), Wal-Mart (WMT), Amazon (AMZN), Intel (INTC) and Gilead (GILD). Other long-time

Being me, I had to sort the list and see which companies were the highest quality using the gross profits-to-assets ratio. The highest quality stock on the list right now is Texas Pacific Land Trust (TPL). This trust is the largest landowner in the state of Texas with the trust is one of the largest landowners in Texas with around 911,217 acres located in eighteen different counties. According to their Web site, Texas Land Trust oil and gas royalties, grazing leases, easements, specialty leases, and land sales.

The Trust has a perpetual oil and gas royalty interest in some 459,200 acres near the Permian basin. The stock has fallen with the price of oil in recent months but it still fits our definition of a high quality company. Over the past 12 months they have produced gross profits of $54 million on assets of $33 million.

As a general rule I am not a fan of chain restaurants with the sole exception being the glory that is the Waffle House. But the screen clearly shows that the better ones are wildly profitable. Cheesecake Factory (CAKE), Cracker Barrel (CBRL), Panera Bread (PNRA) and Papa Johns (PZZA)are all in the top 50 of highest quality stocks.

I am still not going to eat at any of them unless forced by a wife and eldest daughter who think that Panera is lunch time perfection. But I will be checking the quality ratio of the companies before suggesting selling or shorting one of the stocks in the future.

My series on using quality measures not only is identifying some interesting stocks that fit Professor Novy-Marx's definition but it is hoped that they also reinforce the idea that investors need to stay on top of what is going on in finance academia. Yes, some of it is produced by professors meeting the publish or perish mandate and many of the discoveries can and will be arbitraged out of existence in very short time. Some, papers, however, like the work of Robert Novy-Marx and Joseph Piotroski make a lasting and permanent addition to the investing world that helps us become better investors and earn higher long-term returns.

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At the time of publication Melvin had no positions in stocks mentioned.

Ironically, the high level of skepticism makes it more likely that a decent snapback may finally develop.

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